Capital Goods Sector: The Good, The Bad and the Ugly

Demand for industrial goods fell off a cliff in November, but global stimulus efforts could help offset that weakness. Still, it’s a good bet that capital goods producers won’t see a pickup in demand until late 2009 or 2010, meanwhile pension funding pressures could further strain the sector.

First, the good news. In its 2009 Outlook, Morgan Stanley points to massive fiscal stimulus plans in the U.S., Europe and China, with much of the spending aimed at infrastructure projects, as a significant plus.

Still, Morgan Stanley warns that the sector is in the early stages of a capital spending recession and cautions that oil and gas companies and mining companies that are dependent on commodity-related spending will be hard hit.

As this chart from Merrill Lynch shows, the global industrial economy is “falling like a stone” going into 2009, with the U.S. Institute for Supply Management Index diving to a 30-year low in November.

Merrill says investors should proceed with caution, as earnings in the sector will be under considerable pressure in 2009. The firm doesn’t expect a trough until later in 2009 and then only a weak recovery in 2010.

Amid weak demand and falling equity prices, Standard & Poor’s warns the capital goods sector will soon be contending with higher pension costs and funding needs that could further strain liquidity. The following chart shows the asset mix of capital goods companies covered by S & P, which remained heavily weighted toward equities through 2007.

New legislation signed by President Bush last week offers some temporary relaxation of pension funding requirements in the midst of the global credit crisis. Still, S&P is concerned.

We expect that many issuers rated by Standard & Poor’s Ratings Services will soon be confronting additional significant issues brought on by the market turmoil and broad stock market decline: higher pension costs, larger underfunded balances, and higher cash contribution levels that will place added pressure on their liquidity and other credit metrics.

For details, see “Pension Funding Levels Weigh Heavily on the U.S. Capital Goods Sector.”